Silicom Ltd. (NASDAQ:SILC) Stock Is Going Strong But Fundamentals Look Uncertain: What Lies Ahead ?

Silicom (NASDAQ:SILC) has had a great run on the share market with its stock up by a significant 23% over the last three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. Specifically, we decided to study Silicom's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Silicom

How Do You Calculate Return On Equity?

ROE can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Silicom is:

4.6% = US$7.3m ÷ US$157m (Based on the trailing twelve months to September 2020).

The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.05 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Silicom's Earnings Growth And 4.6% ROE

When you first look at it, Silicom's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 8.5%. For this reason, Silicom's five year net income decline of 7.3% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

However, when we compared Silicom's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 1.8% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Silicom is trading on a high P/E or a low P/E, relative to its industry.

Is Silicom Making Efficient Use Of Its Profits?

Silicom doesn't pay any dividend, meaning that the company is keeping all of its profits, which makes us wonder why it is retaining its earnings if it can't use them to grow its business. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Conclusion

On the whole, we feel that the performance shown by Silicom can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. To know the 2 risks we have identified for Silicom visit our risks dashboard for free.

If you decide to trade Silicom, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.